One Stop Systems, Inc. Q2 FY2024 Earnings Call

Good day, and welcome to the One Stop Systems second quarter 2024 Conference Call and Webcast. At this time, all participants are in a listen-only mode. Later you will have an opportunity to ask questions. During the question-and-answer session, as a reminder, this conference is being recorded. As part of the discussion today, the representatives of OSS will be making certain forward-looking statements regarding the company's future financial and operating results as well as their business plans, objectives and expectations. These statements are based on the company's current beliefs and expectations and should not be regarded as a representation of OSS that any of these plans or expectations will be achieved. Please be advised that these forward-looking statements are covered under the safe harbor provision of the Private Securities Litigation Reform Act of 1995. And that OSS desires to avail itself to the protections of the safe harbor for these statements. Please also be advised that the actual results could differ materially from those stated or implied by the forward-looking statements due to certain risks and uncertainties including those described in the company's most recent annual report from Form 10-K, subsequent quarterly reports on Form 10-Q and the recent press releases. These reports and the future filings that OSS will be making with the SEC. OSS disclaims any duty to update or revise its forward-looking statements except as required by applicable law. It is now my pleasure to turn the conference over to OSS President and CEO, Mr. Mike Knowles. Please go ahead, sir.

Thank you, John. Good afternoon, everyone, and thank you for joining today's call. I'm pleased with the progress we made during the second quarter of 2024 as we continue transitioning our business to pursue emerging opportunities within large and growing defense and commercial markets. Second quarter performance was aligned with our plan as we continue to pursue opportunities in AI, machine learning, and edge computing. Highlights for the second quarter of 2024 include: positive segment orders which have outpaced quarterly revenue in three of the last four quarters; sequential revenue growth of 4.3%; expanded customer development revenue; and year-over-year OSS segment revenue growth of 8.3% as adjusted to exclude revenue attributable to a former media customer. We believe these favorable trends are positioning OSS for continued sequential revenue growth throughout the remainder of 2024. This year, we've been focused on two important objectives to take advantage of favorable market dynamics and the healthy pipeline we have developed. First, we are focused on converting our pipeline to orders in our OSS segment. And second, we are pursuing customer-funded development opportunities that we believe will establish OSS as an incumbent on platforms driving future multiyear production contracts. Across our global defense and commercial markets, customers are looking for technology partners like OSS to support their expanding needs for rugged enterprise-class compute solutions. Driving these trends are the emerging requirements for AI, machine learning, autonomy, and sensor processing at the edge. The company's best-in-class hardware and software platforms bring the latest data center performance to harsh and challenging applications that we believe will allow OSS to take advantage of current and future demand trends. Our underlying performance during the second quarter and first half of the year is aligned with our plan. We continue to believe 2024 is creating a strong foundation for sustainable year-over-year revenue growth and profitability in 2025. Even as we navigate growing economic uncertainty and continued weakness in our European markets through 2024, with expected recovery in 2025. So with this introduction, let's take a look at the progress we made during the second quarter in more detail, starting with our efforts to convert our pipeline to orders. Our unfactored pipeline at the end of the second quarter remained over $1 billion. Approximately 70% of our current pipeline is comprised of platform opportunities, which we believe will help drive predictable multiyear revenue and backlog for OSS. I'm pleased with the growth and transformation of our pipeline, reflecting the positive contribution of our sales organization, the strategic investments we are making in product development, and the growing demand for our hardware and software platforms. As we continue pursuing opportunities to grow our pipeline, our operating plan in 2024 remains focused on increasing orders within our OSS segment. For the second quarter of 2024, we saw orders outpace revenue by over 20% for the second quarter in a row. Order growth over the past three months was driven by existing customers in the ground, intelligence, surveillance, and reconnaissance market, known as the ISR market, and from customers in the commercial aerospace market. In addition, we had new customer awards in the air ISR market. We expect many of these new engagements will evolve into multiyear follow-on revenue opportunities in future periods. The second important objective we are pursuing this year is focused on growing our presence on customer-funded development programs. As we mentioned on our first quarter call, we started to disclose separate revenue and cost lines in our financial results associated with customer-funded development projects to show our potential and track new wins. We have defined program-related development work as customer-funded development on our financial statements. Through customer-funded development programs, we are typically providing a more integrated solution compared to the company's historic offerings. In addition, it establishes OSS as a platform incumbent on what is almost always a follow-on production and multiyear support contract. As a result, we expect our business model to benefit from a higher mix of annual recurring revenue and contracted multiyear backlogs in the future. Development relationships are expected to take one to two years before leading to production orders. So, as business scales, we expect to benefit from steady quarter-over-quarter revenue growth while building a solid foundation of potential large-scale program opportunities. I'm pleased to report that customer-funded development revenue increased to $1.4 million in the second quarter of 2024 compared to $365,000 just three months ago. This growth was driven principally by the expansion of an existing relationship with a commercial aerospace customer for the fielding of a new product and follow-on production. As expected, we are seeing increased interest from customers to support their development programs, and we have multiple proposals currently submitted. As a result, we believe we will continue to experience sequential growth throughout the remainder of 2024 in customer-funded development revenue. We also have expanded our product development efforts this year and currently have five product efforts under development in the OSS segment focused on edge computing for both defense and commercial applications. We expect to announce and demonstrate these products in the second half of this year and the first half of 2025. Our second quarter results also reflect strategic investments we are making to support current and future growth. Over the past 12 months, we have added new program management personnel with experience managing large, complex development and production programs for government and defense customers. We believe their experience will allow us to pursue even larger programs for development and production in defense and commercial markets. As I mentioned last quarter, we are developing a new growth-focused multiyear strategic plan. Our markets are rapidly evolving, which has required additional time to finalize our three-year strategic plan. We expect to communicate the growth strategies we are pursuing in our presentation later this year. As we look to the remainder of 2024, I'm excited by the long-term strategies we are pursuing to scale our business and drive profitable growth. Though it has taken some time, I'm encouraged by the growing progress underway as we establish ourselves in our markets. We continue to execute against our near-term transformation plan as we focus on driving orders, building backlog, growing revenue, and improving profitability. While the timing of orders will remain a factor as we get to scale, I'm confident we are building a strong foundation to achieve our long-term growth objectives. I want to thank our team for their continued hard work and dedication as we pursue a compelling growth strategy aimed at building greater value for our shareholders. Looking forward, we anticipate consolidated revenue of approximately $13.3 million in the third quarter of 2024, which accounts for approximately $1.6 million of orders that we pushed to the fourth quarter. Our guidance for the third quarter of 2024 also includes expected OSS segment revenue of $6.3 million, representing 15% year-on-year growth in the OSS segment, partially offset by lower Bressner revenue due to continued softness in the company's European markets. While uncertain economic conditions and softness in Europe may negatively impact our consolidated second-half performance, we believe our leading enterprise-class compute solutions, strong balance sheet, and committed team are well positioned to take advantage of positive fundamentals across global markets and create long-term value for shareholders. With this overview, I'd like to turn the call over to our CFO, John Morrison, to review our second quarter 2024 financial results in more detail. John, please go ahead.

Thank you, Mike, and good afternoon, everyone. Our second quarter 2024 results reflect the ongoing transformation of our business model and continued improvements in orders. As a reminder, the company is comprised of two operating segments. Our OSS segment operates in the United States and is primarily focused and involved in the design and manufacture of high-performance ruggedized edge processing, compute, storage, and connectivity systems. Our Bressner segment operates throughout Europe and serves as a system integrator with standard and custom all-in-one hardware systems and components. Bressner also serves as a channel for OSS products to the European and Middle East markets. The following comments are based upon the comparison of second quarter 2024 results to the second quarter of 2023. For the second quarter, we reported consolidated revenue of $13.2 million, which exceeds our guidance of $13 million. The 23.3% year-over-year decline in consolidated revenue was primarily attributable to a $3.2 million reduction in revenue related to our former media customer and a $1.3 million decline in Bressner revenue associated with slower economic activity in Europe. Lower second quarter revenue was partially offset by new customer-funded development orders and revenue growth from new and existing customers. Looking at our OSS segment, and backing out the $3.2 million impact from a former media customer, revenue at our OSS segment grew 8.3%, reflecting revenue growth from new and existing customers and the initial success in adding new customer-funded development projects. As Mike mentioned, in the first quarter of 2024, we started to separately disclose revenue and cost of sales line items associated with customer-funded development work in our financial statements. Customer-funded development typically represents non-recurring design and development work associated with the introduction of new products paid for by the customer. We expect customer-funded development to grow throughout 2024. Consolidated gross profit in the second quarter was 25.2% compared to 27.9% for the same period last year. The decline in our consolidated gross margin was primarily attributable to our under-absorption of our OSS segment production capacity and additional inventory reserves. Total second quarter operating expenses decreased 31.9% to $5.6 million, which was attributable to the elimination of prior year costs associated with organizational restructuring and outside professional services, and these were partially offset by planned program management and investments made during the quarter. In addition, our financial results for the second quarter of 2023 were impacted by a $2.7 million charge related to the impairment of goodwill and a $1.3 million charge related to the employee retention tax credit. For the second quarter, the company reported a GAAP net loss of $2.3 million or $0.11 per share compared to a net loss of $2.4 million or $0.12 per share in the prior year. The company reported a non-GAAP net loss of $1.8 million or $0.09 per share compared to a non-GAAP net loss of $84,000 or $0 per share. Adjusted EBITDA, a non-GAAP metric, was a loss of $1.3 million compared to a positive adjusted EBITDA of $520,000 in the prior year second quarter. Now, looking at the balance sheet in more detail. As of June 30, 2024, OSS had total cash, cash equivalents, and marketable securities of $11.8 million and total working capital of $32.6 million. This is compared to total cash, cash equivalents, and marketable securities of $11.8 million and total working capital of $35.6 million at December 31, 2023. OSS had no borrowings outstanding on its $2 million revolving line of credit on June 30, 2024, and December 31, 2023, respectively. The company's Bressner operations had a consolidated balance outstanding on its term loans at June 30, 2024, of $1.1 million, down from $2.1 million at December 31, 2023, and $3 million at June 30, 2023. For the six months ended June 30, 2024, OSS generated $1.2 million in cash from operating activities compared to $2 million for the six months ended June 30, 2023. This completes our financial review for the quarter. We would now like to open the call to questions.

Thank you. We will now begin the question-and-answer session. Thank you for waiting. We now have our first question from Tony Felling from Lake Street Capital. Please go ahead. Your line is now open.

Good afternoon, guys. This is Tony Felling filling in for Eric Martinuzzi. Appreciate the time for the question. Do we feel the company is properly staffed for a tighter focus on the defense customers?

Yeah, Tony, I do. And we've made some really good progress over the year to where we are. I think we're very well set to actually scale really well too with the people we have. So going back over the course of the year, just a quick summary. Of course, myself, joined the team, run commercial and defense, but defense background of 30-plus years. And then we brought on a VP of Sales and Marketing, Robert Kalebaugh. He and I worked for a decade together in the defense market. He has over 35 years' experience selling and marketing into, not just in the U.S. but also global defense. And then, as I mentioned in the script, we wanted to augment the team with experienced program managers who are used to running large-scale defense programs that have development, production, and sustainment. So we added two program managers to the staff, each of whom has experience running $100 million-plus programs on the defense side. So we're really well situated there. In addition, as an AS9100 certified company and ISO 9001 certified, we're really well set in policy process quality to meet the standards required for defense and commercial. So I think we're in a really good place to execute against defense programs.

That's great. And I mean, do you think there's any risk in terms of revenue concentration with more focus on the defense customers going forward? Or is that kind of where we're headed?

Can you maybe repeat the front end of that, Tony?

Just revenue risk concentration with more focus on defense customers?

Yeah, I don't think so. When I showed up to the company, we were primarily larger on the commercial side. So as we've kind of increased up to about a 50-50 ratio right now. As we're projecting and we're looking at our pipeline for the next three to five years, we see that same ratio in our pipeline. So I don't think we'll get a revenue concentration specifically that would become a risk. If anything, we've seen quite a deep success here in the first year in broadening out that revenue across more defense customers in addition to the commercial customers that we've had. So I don't see a risk in the concentration in defense.

Appreciate you taking the question. I’ll jump back.

Thank you.

Thanks, Tony.

Thank you. And we now have our next question, and this comes from the line of Brian Kinstlinger from AGP. Your line is now open. Please go ahead.

Great. Thanks so much. Can you speak to the government procurement environment? Are you seeing reasonable sales cycles? Are they still elongated? And then as we enter the new fiscal year for the federal government, which always brings a set of budget delays, what can the company do to ensure a steady flow of orders, if at all?

Yes, Brian, dealing with the U.S. government and defense is similar to the experience in most global Ministries of Defense. What we've observed is that the usual acquisition cycles in markets like the ISR market and their technology roadmaps have remained largely stable. Therefore, I’m not overly worried about the direction of these markets or their requirements. The main issue we've encountered, which has been a trend over the last three to five years, is that the procurement processes are taking significantly longer to award contracts, even for those that have already been designated as winners or sole source. Previously, once a winner was chosen, it might take three to four weeks to finalize things, but now it's not unusual for this to stretch to 12 to 14 weeks, impacting our timing significantly. We've managed some timing challenges, but that presents our biggest risk. Regarding demand, the market requirements and technology processes have remained fairly steady. Looking ahead to next year, we always have concerns about continuing resolutions. The advantage of winning programs the previous year is that these resolutions tend to affect new initiatives. So, the more we secure this year, the more stability we have going into next year. We do remain vigilant about continuing resolutions and collaborate with our customers to plan accordingly. We did have two or three programs this year that were delayed close to seven months past when we thought they would hit just because of the longer continuing resolutions we had this year and then the follow-on impact of them having to get the money appropriated. So the timing issues are definitely something we have to deal with. There’s not much we can do rather than work closely with our customers, have things aligned and ready to go. We have seen some large primes taking into consideration funding smaller companies to protect schedules for awards they know they're going to get but are waiting for. And then the last thing we've been doing is we utilize some of our lobbying efforts to help facilitate programs and timing and movement. Ultimately, if it's a continuing resolution, there's not much we can do. But we do work through our lobbying office to help resolve any uncertainty or put in place anything we can.

Great. And then when you talk about customer-funded development, I assume growth in these programs are leading indicators of larger awards? And if that's the case, how do you think about the average length of a government customer-funded development program? And how long might it take or typically take until it turns into something that I might call production?

Yeah, no, Brian, I think it’s safe to say that for the kinds of programs that we're bidding and we've started to win, we'll generally see the non-recurring engineering or development period beyond the order of 6 to 12 or 18 months. So we're in that 6 to 18-month range depending on the size and scope of the development in the system we're developing. Usually, at the end of that 18 months, you have the initial fieldings. Typically, that's the lower risk, the lower rate initial production. That's usually the first four, five or six prototypes, typically delivered within the first, kind of, three to six months after that development period. And then you roll into the production period which can last anywhere from one to two to three to five years and usually has a technology refresh cycle that rolls up on the back end of that. A perfect example is the Raytheon P8 program we have. There is initial front-end development. We've been on that program for the better part of 7-8 years now, and we're on our second or third technology refresh. We're just finishing some development right now for the next technology refresh update for our system there. So that's the benefit of getting in on these front-end customer development programs. A little bit of a long answer, but between 6 to 18 months depending on the scope is what I would say is average for us on those front-end development.

Thank you. Last question I have, as we start to think about the revenue expectations that we like to think about from the OSS segment. Is there any way you can quantify either the first six months or the trailing twelve months book-to-bill?

Yeah. So we've been tracking this year. So, as I mentioned in the earnings call, the bookings have been outpacing revenue in that OSS segment by a little over 20%. So that would be a book-to-bill ratio of approximately 1.2.

So maybe like 1.2 in this last quarter is kind of the initial valuation?

Yeah. For the trailing six months, the book-to-bill ratio for this year has probably been closer to 1.26. The last quarter here was a little stronger, we were upwards of a little over 1.3. So we're starting to see some pick up on the booking side from a lot of work we initiated last year. And then we're forecasting that to see that continued positive book-to-bill ratio greater than 1 through the next two quarters based on where we see things. The biggest impact would be timing on some contracts and making sure the awards come in as planned. But based on where we're sitting, the majority of the pipeline that we have bid right now, for which we're waiting on awards, is either competitions we've won or sole-source work. So we're feeling pretty confident in the scope and the value that we could potentially pull through. We're working on the timing, as I mentioned, on processing it through the systems.

Let me squeeze one more in. We're at the end of the government fiscal year, and some government businesses typically have a budget influx at this time. This not only benefits the current year but also helps for the following year by providing some budget security against continuing resolutions. Does your business experience a budget influx in September that usually results in a benefit?

Not much occurred last year. On the government side, as they approach year-end and aim to utilize their budget, they typically prefer to purchase additional production or spare parts. If you are already established on a platform, you are likely to see a better return on those year-end funds. We have begun to position ourselves in some of those programs to take advantage of this situation. Additionally, we can access sweep-up funds if certain labs or organizations are keen on early technology implementations for testing in their labs or during exercises. We have strengthened our relationships within defense to pursue opportunities for those looking to buy for experimentation in anticipation of future programs. As we increase our market share in defense, the utilization of sweep-up funds will definitely become a valuable resource. We just need a bit more presence and incumbency on additional platforms, and then we expect to see an increase in our opportunities.

Great. Thanks for answering all my questions.

Thank you, Brian.

Thanks, Brian.

Thank you. And there are no further questions at this time, sir. Please continue.

Okay. John, thank you very much. We appreciate it.

Thank you. This concludes our conference for today. Thank you all for participating. You may now disconnect.